Spring Fiduciary PIERspective

Fiduciary Commentary Q1, 2012

Regulatory Guidance Addresses Retirement Income Annuitization

America’s private retirement systems long-term trend away from guaranteed pensions and toward the self-directed investment style found in defined contribution plans, has placed little emphasis on the distribution phase of retirement. This, coupled with the longer lifespan of retirees, has drawn attention to the many risks present when managing savings in retirement.

In an effort to combat and address these threats, on February 2, the IRS and the DOL issued proposed regulations to make it easier for retirees to manage the risk that they will outlive their retirement savings. The new rules would allow individuals to purchase annuity contracts designed to pay distributions as lifetime income payments.

Qualified Longevity Annuity Contract

The proposed regulations add the term, “Qualified Longevity Annuity Contract” (QLAC) to the Internal Revenue Code. A QLAC is a fixed annuity issued by an insurance company. It must be purchased from the assets of a defined contribution plan including 401(a), 403(b), governmental 457 plans or traditional IRAs (the QLAC rules are not applicable to defined benefit plans, ROTH portions of qualified plans, or ROTH IRAs). The purchase of QLACs would allow participants to hedge against the risk of outliving their retirement savings through the purchase of an annuity that produces an income stream, which begins at an advanced age and continues for the remainder of their lives.

A QLAC must meet specific requirements including a payment beginning no later than age 85 and limit the amount used to purchase the annuity to the lesser of $100,000 (adjusted for inflation) or 25% of the participant’s account balance. QLAC payments cannot be altered, forfeited or surrendered for a lump-sum. Additionally, survivor benefits after the participant’s death would be conditionally allowed. If the sole beneficiary is a surviving spouse, the payments can be paid as an annuity over the spouse’s life, as long as the payments do not exceed the amount paid to the original participant.

The rules also exclude specific types of hybrid insurance products including variable or equity indexed contracts. The products must also maintain restrictions on death benefits and other contract features.

Required Minimum Distributions (RMDs)

The proposed regulations provide special relief from the minimum distribution requirements. RMDs are typically calculated from the prior year-end account balance of a retirement plan or IRA. The rules would modify the current RMD rules to facilitate the purchase of longevity annuities by providing an adjustment to the year-end balance by the value of the QLAC.

Annual Reporting and Disclosure

A new concept in the proposal is the designation of a responsible party to provide IRS reporting and disclosures to plan participants. In this case, it is the issuer of the investment product, not the administrator of the plan, who is the accountable party required to provide annual, calendar year reports to the IRS and disclosures to the annuity owner.

Plan Administration

The proposed regulations (and a related revenue ruling) confirm that an annuity contract can be treated as a plan investment rather than a plan benefit arrangement. This distinction provides clarity that annuity payments can be paid under the terms of the annuity contract rather than having to structure the annuity to conform to the terms of the plan document.

Portability of guaranteed products has been a concern for some time. Unanswered questions relating to the insurance contracts upon plan termination or the transition of plan recordkeeper were sources of unknown liability to plan sponsors. The proposed regulations support the notion that the transition of contracts would be treated as an in-kind distribution from the plan.


Longevity risk has surfaced as a crucial issue to the nation’s retirement system. In recent years we have witnessed the first attempt of financial product manufacturers to introduce retirement income management and annuitization products to the retirement marketplace. These proposed rules will serve as a starting point to a larger regulatory initiative and streamline the process through which guaranteed products can be offered in IRAs and defined contribution plans. Future guidance will surely address the many issues yet unanswered, but for the present, the path seems clear for the development of future products.

Legal Corner

Court Decision Provides a Glimpse at Current ERISA Fiduciary Thinking

In the Prudential Retirement Insurance and Annuity Co. (Prudential) v. State Street Bank and Trust Co. case, the Southern District of the New York US District court decided against State Street. The court’s February 2012 decision concluded that State Street had violated its fiduciary duties under ERISA and awarded Prudential $28.1 million in damages. Prudential claimed that State Street breached its fundamental fiduciary duties by failing to manage the bond funds prudently, failing to manage the bond funds solely in the interests of the plans, and failing to adequately diversify the assets in the bond funds.

Shortly after the start of the financial crisis, several plaintiffs sued financial service firms claiming the mismanagement of pension funds by investing in poor performing subprime mortgage-backed securities. Although some of these ERISA lawsuits were class actions on behalf of employees, others were suits against investment managers alleging the mismanagement of plan assets and breaches of fiduciary duty.

Prudential brought suit against State Street on October 1, 2007, on behalf of nearly 200 qualified retirement plans that invested in two bond funds managed by State Street through Prudential separate accounts. Prudential sought to recover losses incurred by the plans resulting from their clients’ investments in the State Street managed bond funds. Prudential alleged that State Street was both an investment manager and a plan fiduciary.

The court found State Street liable for ERISA violations and awarded damages to Prudential for losses sustained as a result of this breach. They also concluded that State Street was classified as an ERISA fiduciary because it “exercised authority and control over management of the plan’s assets.” It was considered an investment manager under Section 3(38) of ERISA and thus a prudent expert standard was required of its actions.

The court found State Street had violated its ERISA mandated fiduciary duties with respect to:

  • Duty of Care, Skill, Prudence and Diligence – ERISA requires fiduciaries to act with the care, skill, prudence and diligence. The court found State Street had breached its duty to act prudently in managing the bond funds and the place bond funds have in the construction of a portfolio. Further, State Street’s investigation into the subprime securities seemed to have been ignored when analyzing the risk of the subprime mortgages.
  • Duty of Loyalty – A fiduciary must fulfill its duties “for the exclusive purpose of … providing benefits to participants.” The court did not find any evidence of breach of loyalty by State Street though determined that it had acted imprudently (as stated above) in the management of the bond funds.
  • Duty of Diversification – The court determined that State Street breached its duty to diversify plan assets. The court found State Street investment in subprime securities was an “undiversified risk for the bond funds.” The case is an important reminder of the basic requirements and duties required of plan fiduciaries and investment managers under ERISA.


End of the Road for Stretch IRAs?

Regulations currently permit beneficiaries of inherited retirement accounts, including 401(k)s and IRAs, to stretch distributions over their individual life expectancies. Depending on the age of the beneficiary, retirement assets could remain in tax-sheltered accounts for decades and accumulate plentiful assets for their heirs.

The Senate Finance Committee attached a proposal to the recent Highway Bill requiring retirement accounts to be fully liquidated within just 5 years after the death of the account owner for non-spouse beneficiaries. Although the initiative did not survive committee, the proposal was estimated to raise $4.6 billion over 10 years from accelerated tax collections.

This failed proposal is an important reminder about retirement tax policy: the idea behind the preferential tax treatment for IRAs and other qualified accounts is to assist individuals to save for their own retirement, not to make tax-advantaged gifts to heirs. As budget pressures continue to be at the forefront of tax policy, North Pier believes this issue could again surface in future budget debates. Additionally, this issue reminds us that the rules we often use as the basis for making financial decisions (often large ones) can change with the stroke of a pen.

Federal Thrift Savings Plan to Offer ROTH

The Federal Thrift Savings Plan is set to unveil its new ROTH investment option to Federal employees by late April or May. If the experience of the private sector is any indication of what the federal government might expect when offering ROTH contributions to employees, it may take longer than expected for employees to embrace its benefits. After becoming available in 2006, many companies amended their 401(k) plans to offer the opportunity to make ROTH deferrals. However, many employees have not yet adopted ROTHs nor made
them part of their savings strategy.

Despite the marketing of the potential benefits of a ROTH, namely, tax-free withdrawals, tax diversification and RMD avoidance, the adoption rate of ROTH deferrals in 401(k)s has been anemic. Some of the nation’s largest recordkeepers have seen ROTH participation rates ranging from as little as 6% to 15% of participants.

Although the ROTH 401(k) is easy to understand, many believe that this sluggish uptake is due in part to the challenging financial assessment that is required to determine if ROTH contributions are advisable, thus preventing participants from making the switch.

Reasonable Rate of Interest

In a recent IRS discussion forum regarding participant loans, an IRS representative stated that interest rates on participant loans of a rate less than the prime rate plus 2% might not meet the reasonable standard as required under the Internal Revenue Code. After clarification, the IRS identified previous DOL guidance on the determination of a reasonable interest rate for a participant loan. Several examples highlighted from DOL regulations described a process that should be followed when determining a reasonable rate. They include the current commercial lending rates for loans to individuals of similar creditworthiness, not necessarily the prime rate plus 2%.

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